For years there were two books that I recommended to people who wanted advice on investing. One, by Andrew Tobias (which I'll post a review of presently), was for people who viewed investing at least partially as a source of entertainment--people who were interested in the process as much as the result. The other, John C. Bogle's previous book, was for people who just wanted the best possible long-term investment return with the least effort. Now that I've had a chance to read Bogle's new book, I can confidently start recommending this one instead. In fact, I'll start recommending it to both kinds of investors.

As the title claims, it is quite a little book--you can read it in an afternoon. Its compactness comes in large part from the simplicity of its message:

For maximum return, invest mostly in stocks. Bogle does recommend including bonds in your portfolio, initially as a small percentage that grows as you approach retirement, but you cannot expect much in the way of long-term growth from the bond portion of your portfolio.

Invest for the long-term. Bogle points out that the time horizon for an investment shouldn't be calculated just to until the investor expects to retire, but rather to until he expects to die--at least 50 years for a young investor, and quite possibly 20 years or more, even for someone who has already retired

Invest in index funds

The virtues of index funds are a focus of the book; the main ones are:

The whole return of the equity market. Since mutual funds are such a large part of the entire market, they are by and large buying from and selling to one another. The upshot of that is that a profit for any one fund is almost by necessity a loss to some other fund. Buying an index fund let's you avoid all that.

Low expenses. The costs of management and the expenses of trading come directly out of the fund's assets. If you keep trading to an absolute minimum, you avoid trading costs. And, if you're not trading, you scarcely need any management.

Tax efficiency. If your fund trades, you owe taxes on the capital gains each year. An index fund, since it scarcely trades, postpones the tax bill, potentially forever. (If you die still owning the stock, your heirs need not pay the capital gains taxes.)

There's a discussion of bond funds, to which the same discussion applies, only more so, as the opportunities for great management producing higher returns are limited in a bond fund, and the expenses eat away all the more fiercely at a generally smaller return.

After minimizing your costs (by buying index funds), the next most important determinant of total return is the asset allocation. This area is one I find interesting, and Bogle gives it only a very brief mention. Brief as it is, though, it covers the topic adequtely for anyone who is just trying to make a good return without having to spend a lot of time thinking about their investments.

There's discussion of the issue of "fun" investing--the sort of investing where the investor makes decisions because he or she wants to feel involved. Bogle admits that there's a roll for that, if only to teach yourself by first-hand experience that just buying the whole market through an index fund is a winning strategy.

I used to recommend Bogle's earlier book Bogle on Mutual Funds: New Perspectives for the Intelligent Investor, which remains an excellent choice. The main difference between that book and this (besides some updating) is that this book drops a lot of the earlier book's advocacy of reform in the mutual fund industry. I'm not sure how much of the change is because the battle has, to some extent, been won (low-cost index funds are now readily available) and how much is because Bogle has written another book on that topic in particular. Either way, the change is a good one: The Little Book of Common Sense Investing covers one important topic in a brief but comprehensive way.

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Steve #1

Thanks for the article Philip.

If I may, I would like to play devils advocate. I have been hearing so much talk about index funds and do it yourself type investments.

I have some questions and I would love to hear your opinion.

Index funds are 100% equity, what does one do if they are not aggressive investors?

What if the index is not diversified?

I'm from Canada so I will speak about our major index the S&P TSX. In 2001, Nortel made up 36% of the index and even today, almost 50% of the TSX is made up of natural resources. I find that owning an index fund can give you the perception of diversification, by often that is not the case. Just as I would have had to been out of my mind to have 36% of all my holdings in Nortel in 2001, I would have to be equally insane to have almost half my holdings in natural resources today.

I'm assuming that these types of diversification issues would be likly the same with most indexes as huge conglomerates such as Wal-Mart and GE would make up large portions of any index.

Should I just forego diversification in the hopes for better returns?

One of the reasons I'm asking is because I had a friend back in 2000 that swore by index funds. He lost over 50% of his money within 2 short years.

Bogle talks specifically about the US equities market. He compares the S&P 500 index to a total-market index and concludes that the reduced market coverage is more than made up for by the reduced cost of just dealing with a few hundred highly-liquid stocks. Because most major US companies do substantial business overseas, he doesn't think it's important to add an additional "international" component to the portfolio.

The Canadian investment market is small enough that it probably isn't adequately diversified all by itself. The S&P 500, though, isn't bad: The top five companies (ExxonMobil, General Electric, AT&T, Microsoft, Citigroup) are all in different industries and only add up to a little over 12% of the index. And the concentration tapers off fast--before you're through the top 20, the contribution of each company is under 1%. (See index component weights for details.)

The question of how you can get adequate diversification in a smaller, more concentrated equity market is a tough one. Once you move away from the index concept, you lose the big advantages of an index fund (low cost, guaranteeing your share of the total market return), so just saying, "Oh, it'll be like an index fund, only we'll avoid being overconcentrated in any particular company or industry," is no solution.

Bogle was the guy who founded Vanguard and who more-or-less invented the S&P 500 index fund. I'm not sure what advice he'd give to a Canadian investor, but I wouldn't be surprised if it amounted to, "Buy the S&P 500."

Although the S&P 500 looks more diversified than the TSX, I notice that the biggest 50 companies make up 50% of the entire index which leaves the other half of it's capitalization spread across the other 450 companies.

I understand the concept of index funds. However I'm not yet sold on them as the magic bullet many claim they are.

I invest in Vanguard and have all my money in the Australian shares index fund that tracks the S&P/ASX 300. Like the previous poster I am worried that I am underdiversified because the top Australian companies tend to be resource and finance companies.

Bogle says you should invest in in American firms, but that is tantamount to a religious person believing only his religion is right because he was born and bred that way. It's emotional reasoning based on instincts of trust and familiarity.

Vanguard Australia offers LifeStrategy Funds that invest in multiple areas. The High Growth Fund invests in about 40% Australian shares, 20% International Shares, 20% property trusts, 3% emerging markets, and so on. The fees are slightly higher if you are investing under $100,000 but over that the fees are no different to those funds that track only Australian shares. What I want to know is whether these LifeStrategy Funds are in the spirit of Bogleism. They are better diversified, but the 40% invested in Australian shares is arbitrary and selected by the experts at Vanguard. This then is similar to active investing.

Since more than one reader has expressed an interest in this question, I've sent some email to John Bogle to ask him. I don't know if he'll have time to send a response, but if he does I'll post it here.

I'm an investing book junkie and read this book at Philip's recommendation over in the forums. It is indeed well written. Bogle makes a thorough, rational case for investing solely in broad, total-market index funds. I appreciated the matter-of-fact, confident, practical tone.

I hesitate to recommend it as a one-book investing education. Bogle discusses asset allocation only briefly, and never directly addresses the money management topics that ought to be a prerequisite to investing -- mindful spending, a cash reserve, adequate insurance, and so on. Those things aren't "investing" per se, but they are essential topics and there are other books that cover them in addition to sensible investing advice.

I do quibble with Bogle's advice to split stocks 80/20 between the US and ex-US. He presents slam-dunk arguments for the advantages of indexing "everything," and the disadvantages of weighting any one category of stocks over another. To me the natural conclusion is to weight the US/ex-US according to their respective market capitalizations, possibly using a "total world stock" index fund. For some reason Bogle persists with his position that overweighting is inefficient and wasteful, except in the one case of country of origin.

It's a great book, though, for someone who already has their finances in order and needs to be convinced or reassured of the virtues of Bogle's simple approach. I think I'd still recommend Tobias' "The Only Investing Guide You'll Ever Need" as a first and (possibly only) personal finance book. "The Little Book..." is a wonderful second (and possibly last) investing book.